US-EU trade dispute on course for escalation

The EU has retaliated against the US administration's decision to apply tariffs on steel and aluminium imports with tariffs on €2.8bn worth of US imports. These came into effect on June 22nd.

The dispute is unlikely to end here. Donald Trump, the US president, is preparing to respond with tariffs on car imports from the EU.

If US car tariffs are imposed, we expect the EU to retaliate again with further measures, the impact of which would be felt in 2019.

However, we expect the conflict to stop short of a full-blown trade war as the mounting costs of tariffs increase the political pressure to refrain from further escalation.

On June 1st the Trump administration let the EU's exemption from import tariffs of 25% on steel and 10% on aluminium expire, despite a series of bilateral talks aimed at reaching a limited trade agreement to avoid the tariffs and reduce the risk of a full-blown trade war. The EU had offered to lower car tariffs, which Mr Trump views as a major cause of the US-EU trade imbalance that he would like to redress. EU tariffs on US car imports currently stand at 10%, compared with 2.5% for US tariffs on EU car imports.

The EU has adopted retaliatory measures within the framework of World Trade Organisation (WTO) rules on dispute settlement. "Rebalancing duties" worth €2.8bn came into effect on June 22nd. These are tariffs of 10% or 25% on a range of US goods, and are the EU's response to the US tariff on steel. A further €3.6bn worth of tariffs will be applied on June 1st 2021 or after a successful outcome of the WTO dispute settlement case (whichever is sooner) in response to the tariff on aluminium products and "other" steel products. The EU also launched legal proceedings against the US, and an investigation into steel products to prevent trade diversion; the European Commission has nine months to decide whether to impose tariffs or quotas on imports of steel from all countries.

The EU's decision to retaliate was less about the economic impact of the steel and aluminium tariffs—which account for less than 2% of total EU exports to the US—and more about defending the rules-based international order against the US action, which the bloc has said contravenes international trade law. The EU is seeking to safeguard EU interests against what it has called "pure protectionism".

The dispute is unlikely to end here

The tit-for-tat trade conflict is unlikely to end with the EU's retaliatory tariffs. The tariffs were imposed on quintessentially American products such as bourbon whisky, orange juice, motorcycles and jeans—with some focus on products manufactured in Republican states, in order to have maximum political effect ahead of the US mid-term elections in November.

Harley-Davidson, a US motorcycle manufacturer based in Wisconsin (the home state of Paul Ryan, the Republican Speaker of the House of Representatives), announced on June 25th that it would be shifting some of its production out of the US in order to avoid the EU's tariffs, which it said were a threat to its sales. The company said that it would bear most of the increased cost of the EU tariff on motorcycles—now at 31%, up from 6% previously—which could total US$30m-45m for the remainder of the year.

We assume that the US administration will not back down in the short term. The announcement by Harley-Davidson did not go down well with Mr Trump, who said that the company had "surrendered" and warned that it would be "taxed" for the move. Mr Trump is pressing ahead with his Section 232 investigation into whether imports of automobiles—including sports utility vehicles (SUVs), vans and light trucks—and automotive parts are weakening the domestic industry and threatening to damage national security.

Mr Trump is keen to demonstrate to his political base that he has taken the fight on trade to China and Europe and achieved results. This was one of his key election promises; being able to show that he is following through on this will play well with his core support base ahead of the mid-terms. Mr Trump wants to have completed the Section 232 investigation by August so that he can take action on car tariffs ahead of the elections. However, the administration will face increasing pressure from lobbyists and industry groups that will be negatively affected by tariffs—particularly those representing American farmers and manufacturing firms—as these raise input costs and hurt their export competitiveness. Regardless of such considerations, the Trump administration is likely to remain tough on trade beyond the elections.

We expect the EU to retaliate again

Mr Trump announced by tweet on June 22nd that the additional tariff on cars would be 20%. Although earlier attempts at US-EU bilateral co-operation on trade failed, the stakes are higher now, and the EU may consider pursuing this again. Germany in particular has an interest in avoiding the imposition of car tariffs, as this would be damaging for its domestic automotive industry, which exported about €30bn worth of cars and car parts to the US in 2017, equivalent to 12% of Germany's car exports and just over 2% of its total exports. The car industry is already reeling from the "dieselgate" scandal in 2015, when it was discovered that Volkswagen had misled regulators in emissions tests in the US. It is also worried about the EU's tough CO2 emissions targets as part of its long-term climate change strategy, as well as the impact of Brexit.

If the EU were to take a more emollient approach, Mr Trump could delay and even, eventually, desist from imposing higher tariffs on EU cars. This is possible, given that the president already seems to have shifted his attention to China, which is ultimately the main focus of concern for the US. However, the rhetoric suggests that the EU is already poised to retaliate against US car tariffs. The French president, Emmanuel Macron, and EU institutions are pushing for a more robust response. Countering pressure from the automotive industry, which will be lobbying national governments to avoid tariff imposition, will be the political pressure across member states not to give into Mr Trump. If US car tariffs are imposed, we therefore expect the EU to retaliate again, probably with another round of new tariffs imposed in early 2019. As the costs of these tariffs become more obvious, political pressure on the US administration to refrain from further escalating the dispute will increase. Congress is also less supportive of escalating the trade conflict with the US's allies than with China.

Economic impact will be limited, but bilateral relations have frayed

The exchange of these tariffs will have a fairly limited impact on the economies of the EU and the US in the short term. Most of the impact will not be felt until 2019, and will depend on the extent to which the tariffs are absorbed by companies and how much is passed on to consumers. In the case of car tariffs, even if the extra cost is passed on, the relative price inelasticity of high-end European cars should mean that demand for them remains largely resilient. As a result, although demand and production might be affected at the margin, the direct impact on the economic outlook for Germany and other car producers in the EU could be relatively minor.

Nonetheless, the tariffs will be disruptive to business, and market uncertainty over future trade policy will weigh on investor sentiment. A further escalation of the trade conflict would increase the economic impact. However, we expect it to stop short of a full-blown trade war. The prospect of a limited industrial goods trade agreement will remain on the negotiating table and, if achieved, could allow Mr Trump to claim that he has levelled the playing field on trade relations with the EU. The greater concern is the impact of this conflict on bilateral relations, which are likely to remain noticeably weaker for the duration of the Trump administration.